Five ways to play the housing slump

ORLANDO, Fla. -- Aug. 1, 2006 -- If you didn't buy a house while prices in Las Vegas zoomed 46 percent in 2004 and 15 percent last year, maybe you felt like a sucker. But given that the Standard & Poor's Homebuilding Index has skidded nearly 38 percent so far this year, you probably feel lucky if you don't own real estate stocks. But are you brave enough to bet against conventional wisdom and buy real estate stocks now?

Even if you are, bear in mind that it's hard to find five stock picks in real estate now. And forget about finding short-term slam dunks for investors. Yet there are a handful of ways to approach real estate's uptick -- whenever it happens. We reached out to an economist, a top industry exec, and two S&P stock analysts to generate five ideas to help you think about investing in housing. You can't expect to get rich courtesy of any of these, but they might help you feel lucky down the road.

1. Be long term.

Mark Zandi, chief economist for Moody's (MCO) Economy.com, predicts existing home sales will fall this year, next year, and again in 2008. Same for housing starts. He figures home prices will rise 4 percent (national average) this year (compared with 13 percent in 2005), and 1 percent in 2007 and again in 2008.

Those are the three big levers driving the housing market, and none of them look strong. After the 1990-91 recession, it took housing until about 1995 to get truly healthy again. The recovery probably won't be as tough this time, Zandi says, because the job outlook is much better. It helps that the real estate correction isn't coming at the same time as big defense cuts and a general recession, as in the early 1990s. But housing is likely to wallow for a while. "The downturn we're in the middle of has at least a year to run, perhaps two," he says.

2. Watch the Cendant deal.

The conglomerate Cendant (CD) is splitting into four companies, three of which start trading publicly. (The fourth, which owns some of Cendant's travel businesses, is being sold to a private-equity outfit.) The one that matters here is Realogy, which is by far the nation's biggest real estate agency and franchisor, owning the Century 21, ERA, and Coldwell Banker brands. Its relationships reach 25 percent of U.S. existing home sales that use a broker, a share so big that its New York Stock Exchange ticker symbol will be H, as in housing.

The interesting thing about Realogy is it can serve as a proxy or neo-index for the housing market. If you think housing's decline will be manageable followed by an eventual resumption of a long-term secular trend, Realogy is a good place to be.

However, the business is not super now. Chief Operating Officer Richard Smith says earnings before taxes and noncash charges will be $925 million to $1.045 billion this year, down from $1.17 billion last year, on about $7 billion of revenue. He says the company hopes to beat the industry's performance by focusing on high-margin franchising businesses that usually gain share in recessions. (That is, when times get tough, regional agencies that had resisted paying 8 percent of their revenue for a franchise affiliation give up and align with the national brands.) But, warns Smith, "you have to understand there will be macro issues, and you have to deal with it."

3. Think geography -- and value.

Look for companies with more exposure to markets that have not had big runups in housing prices and less exposure to markets where prices have skyrocketed and will most likely come down. In other words, more Texas and less Florida.

One reason S&P is so bearish on homebuilders is that almost all the big ones are heavily exposed to Florida. Analyst William Mack rates only Dallas-based Centex (CTX) a buy (4 STARS), because it has less debt than most of its peers and gets at least some of its revenue from a construction-services business that does nonresidential work.

Mack has a strong sell (1 STAR) recommendations on Meritage Homes (MTH), MDC Holdings (MDC), Levitt (LEV), and Beazer Homes (BZH). He has sell rankings (2 STARS) on Hovnanian Enterprises (HOV), Ryland Group (RYL), and Pulte Homes (PHM).

If you're looking for a bargain, builders have actually become cheap, with most trading below their book value and a handful even hanging below their tangible book value. That's one reason homebuilders have caught the eye of value mavens at Legg Mason Value Trust (LMVTX), which owns Ryland, Beazer, Pulte, and Centex. But those positions have been in place for months, Mack says, so don't take it as a sign of a quick turnaround. "If they liked the valuations then, they've got to love them now," he quips.

4. Don't chase performance.

One of the real estate plays that has done better than most is real estate investment trusts (REITs) tied to apartment buildings. REITs offer steady income since they pay out at least 90 percent of their taxable income as dividends. Plus, deteriorating affordability for home buyers will boost occupancy of apartments.

The problem is, apartment REITs have gotten very expensive -- and, on average, offer less than a 4 percent dividend yield. "It's tough to say, 'Buy them as a contrarian move,' " says S&P REIT analyst Royal Shepard. Apartment REITs that he follows are trading at 21 times funds from operations -- a cash-flow multiple higher than many Internet stocks, without nearly as much long-term growth potential.

Shepard has sell opinions on seven of the 11 REITs he follows. If you want stability, performance, and some income, a better bet is a mortgage operation such as IndyMac Bancorp (NDE) or Countrywide Financial (CFC). IndyMac yields 4.1 percent, it's up for the year, and it's gained a reputation as a particularly tech-savvy, cost-conscious operator.

5. Big brands gain share in real estate recessions.

This is especially true in home building, where access to capital and ability to hold on during tough times play such a large role. But it's also true for brokers. You can probably buy the leaders a year from now and get them at least as cheaply as you can at present. But the housing recession isn't a depression, and there will be a big, vital industry left standing when the storm passes.

Smith argues that house prices have risen nearly 5 percent a year through the decades, once you factor out the surges and the busts. And people move about every seven years. So the best thing to do is watch for the companies that are built to withstand the downturn and grab more market share while sales shrink. They're the ones that are likeliest to zoom when the economy puts some wind back in their sales -- whenever that is.